How will the bailout work?

WASHINGTON - September 22, 2008 - Among the unanswered questions: How will the government mop up the bad mortgage debt on banks' books, who will run the process and how much will it cost?

Key elements of the plan remain in flux as behind closed doors Democrats demand modifications that would provide more help for ordinary Americans in return for bailing out the country's financial giants.

In the spare, three-page draft legislation that the Treasury provided lawmakers on Saturday, the administration's plan seemed straight forward enough.

The Treasury asked for $700 billion which it proposes to spend over the next two years to purchase what Treasury calls "troubled assets" from financial institutions including banks, thrifts, credit unions, broker-dealers and insurance companies.

The assets are defined as residential and commercial mortgages and any securities based on those mortgages if the debt was issued before last Thursday.

The Treasury's first draft said that only mortgage-related assets would be purchased. But in a later version the Treasury secretary asked for the power, after consulting with the chairman of the Federal Reserve, to expand purchases to troubled assets beyond real estate if both officials determine such purchases are necessary to promote market stability.

That would conceivably leave taxpayers picking up the tab on things like bad car loans and credit card debt. The Treasury will likely focus virtually all of its attention on the mountain of bad mortgage debt, however, since that is at the heart of the 14-month long credit crisis.

How would the purchase of this bad debt work? Again, the Treasury draft legislation leaves a lot to the imagination. But Treasury officials have talked about employing a "reverse auction."

Under the process, the Treasury would advertise an auction, seeking to buy, for example, $1 billion of subprime mortgage loans that were originated around the same time.

In a reverse auction, the financial institution burdened with the bad loans agrees to take the lowest amount bid for the package. A bid of 50 cents on the dollar for a bundle of bad loans would beat out someone only willing to take 60 cents on the dollar.

The banks get to unload their bad debt and the government holds the asset either until it reaches maturity or until the market improves enough for the asset to be sold, perhaps for a profit.

This auction process holds one big advantage, economists say, while also posing a major risk for some financial institutions.

By purchasing the debt, the government would be creating a market that makes pricing easier and more uniform among institutions. That could clear up a huge amount of uncertainty in the market for subprime mortgages. But the clarity could bring bad news to some institutions: The writedowns they have taken so far could leave them with inflated prices for the bad debt remaining on their books.

In the worst case, it could cause some institutions to fall below the capital cushions they are required to hold against loan losses. That could produce a wave of bank failures. Given that threat, many financial institutions might be reluctant to participate in the auctions.

"If you try to low-ball the financial institutions too much, they won't take it because they can't take the capital hit," said Brian Bethune, an economist at Global Insight, a Lexington, Mass., consulting firm. Some economists argued that the program could be a big bust simply because enough financial institutions won't participate.

Still, the bailout package is far from final. Democrats are seeking changes that would benefit consumers, among them proposals that would limit pay packages for financial company executives and allow judges to rewrite mortgages to lower the monthly payment of bankrupt homeowners.

Pessimism surrounded the bailout Monday as the Dow Jones industrial average fell more than 370 points as analysts predicted the $700 billion bailout coupled with the $200 billion committed to take over mortgage giants Fannie Mae and Freddie Mac could cause the government to boost its borrowing.

The Bush administration is already forecasting that the federal deficit will hit a record $482 billion next year. Analysts said it is possible that the various bailout costs and the weakening economy could give the country its first ever $1 trillion annual deficit.

Other economists have a more optimistic view about the chances of success for the whole program. They believe a sizable number of financial institutions will jump at the chance to unload their bad debt on the government and freed of the bad loans, they will resume more normal lending operations, giving a boost to the economy.

"The cost to the government would be much larger if no action is taken and the financial system unravels further and takes the economy down with it," said Mark Zandi, chief economist for Moody's

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